Statement by E. Gerald Corrigan Before the U.K. Treasury Select Committee

Feb 2010 Source: Goldman Sachs


Chairman McFall and Members of the Treasury Select Committee, I very much appreciate the opportunity to appear before you this afternoon to offer evidence on the critically important subject of “Financial Institutions – Too Important to Fail.” I am hard pressed to think of any subject that is more central to the cause of greater financial and economic stability than is our collective efforts to put behind us the all too obvious fact that the financial crisis of 2007-2008 forcefully demonstrated that taxpayer money was widely used to “bail-out” financial institutions that were seen by governments and central banks as too big, too connected and/or too important to fail.

As the Select Committee knows very well, financial excesses were unquestionably one of the causes of the crisis, but shortcomings in public policy were important contributing factors. Similarly, not all “banks” that received direct taxpayer support were large and complex institutions. It is also very important that we all recognize that the largest single source of write-downs and losses in financial institutions – complex or not – occurred in lending, not trading, activities. Regrettably, these lending-driven losses and write-downs were magnified by certain classes of securitization especially very complex and highly leveraged instruments. Finally, it is also undeniable that all classes of financial institutions – big banks, small banks, investment banks (including Goldman Sachs) and so-called near banks – to say nothing of businesses small and large – benefited substantially from the large scale extraordinary measures taken by governments and central banks to cushion the economic and financial fallout of the crisis.

During the darkest days of the crisis in September and October of 2008 we witnessed a near total collapse of public and investor confidence in financial reporting and loss recognition at financial institutions. In the worst of individual cases, the asset quality problems that were raising questions about capital adequacy and solvency resulted in a situation in which the immediate threat on individual institutions shifted from the asset side to the liability side of the balance sheet and took the form of electronic “runs” on banking institutions. In other words, when serious questions arose about an institution’s capital adequacy, sources of funding, even funding by secured creditors and counterparties, evaporated quickly. To an extent, this phenomenon applied even to strong institutions, given the limited ability of market participants to differentiate among institutions.

This chain of events is the reason why capital adequacy and liquidity adequacy must be treated as a single discipline. It is also why efforts by seriously troubled institutions (or their regulators) to raise capital, sell businesses or merge are almost immediately confronted with questions as to the quality of their valuations. Indeed, regardless of the extent to which individual institutions use mark-to-market accounting, questions about the reliability of valuations or “marks” will not go away. This is only one of the reasons why I have become a strong advocate of fair value accounting for financial instruments and institutions.

Looking forward, I strongly believe that the number one post-crisis priority is the agenda for reform that is summarized in Section I of this Statement. If we are successful in achieving these reforms in a reasonable period of time, I am very much of the view that the case for wholesale restructuring of the core of the financial system would hardly be compelling. On the other hand, if we fail to achieve these reforms, financial restructuring might result in a financial system that is more – not less – accident prone. For these reasons, I am not persuaded (as discussed in Section II of this Statement), that any approach calling for a major restructuring of the financial system is warranted particularly since I am doubtful that anything approaching an international consensus on any such plan can be reached. In saying this, I do take comfort from the fact that in most major jurisdictions, the authorities already have sufficient power to deal with problem institutions on a case-by-case basis. This, of course, implies that “Prompt Corrective Action” must become a reality and that all systemically important financial institutions must be subject to consolidated prudential supervision and Enhanced Resolution Authority.

The “wild card” in all of this lies in the challenges associated with Enhanced Resolution Authority as described in Section III of this Statement. Even within national boundaries, this is an extraordinarily complex subject. The complexity arises from the fact that technologically-driven contemporary finance itself is very complex and is subject to various sources of inherent contagion risk. Partly for these reasons, “Enhanced Resolution Authority” has great political and public support since it is seen as the “solution” to taxpayer bailouts of large and complex financial institutions. In these circumstances, the promise of “Enhanced Resolution Authority” will only be achieved if it is designed and executed – nationally and internationally – with great precision. In that spirit, I have outlined in Section III of this Statement certain “Guiding Principles” and “Pre-requisites for Success” which I believe are central to delivering on the promise of “Enhanced Resolution Authority.“

Section I: The Financial Reform Agenda

In looking to the future, almost everyone who has seriously studied the causes of the crisis agrees that certain basic reforms are a must both at the national and international level. In summary form, those basic reforms include the following:

1. The creation of a so-called “systemic regulator.” Among other things, the mission of the systemic regulator would include oversight of all systemically important institutions and, importantly, looking beyond individual institutions in order to better anticipate potential sources of economic and financial contagion risk including emerging asset price bubbles. Anticipating future sources of contagion is difficult but it is not impossible.

2. Higher and more rigorous capital and liquidity standards that recognize the compelling reality that managing and supervising capital adequacy and liquidity adequacy must be viewed as a single discipline.

3. Substantial enhancement in risk monitoring and risk management and more systematic prudential oversight of these activities.

4. The increased reliance by institutions and their supervisors on (1) stress tests; (2) so-called “reverse” stress tests; and (3) rigorous scenario analysis of truly extreme contingencies.

5. Efforts to intensify the never-ending task of strengthening the infrastructure of the global financial system.

6. The creation of a flexible and effective framework for the timely and orderly winddown of failing large and complex financial institutions (the Enhanced Resolution Authority discussed in Section III).

7. Substantially enhanced cross-border cooperation and coordination on a wide range of issues including, but not limited to (1) accounting policy and practice; (2) more uniform prudential standards; (3) the design and implementation of Enhanced Resolution Authority; and (4) better coordinated macro-economic policies, especially as applied to medium-term reductions in fiscal deficits.

In the US, the UK, continental Europe and elsewhere, governments and central banks are hard at work in efforts to implement reforms along the broad lines of this agenda. Having said that, I want to underscore three key points; First; the execution challenges associated with this reform agenda are enormous. Second; the reforms are a “package deal” such that if we fail to achieve any one of these measures the prospects for success in the others will be compromised. Third; if we are successful in implementing the reform agenda over a reasonable period of time the case for wholesale restructuring of the financial system would hardly be compelling. On the other hand, if we fail in these efforts, even the most far reaching efforts to restructure the financial system and its regulatory apparatus will provide little assurance that the probability of future financial shocks – and the damage caused by such shocks – will be materially reduced.

Section II: Alternative Financial Structures in Perspective

At the risk of considerable oversimplification, there are three somewhat overlapping suggestions on the table concerning the structure of the financial system going forward. The first such alternative would limit the activities of “banks” to classic utility functions of gathering deposits, making loans and providing payment services. This view is widely associated with Governor King of the Bank of England. The second approach would limit the scope of activities in “banks” and in companies that own banks but would allow nonbank affiliates of Bank Holding Companies to conduct certain other financial activities including the underwriting of debt and equity securities while sharply curtailing or prohibiting banks and bank holding companies from engaging in “proprietary” trading and operating or sponsoring hedge funds and private equity funds. This view is widely associated with the former Fed Chairman Paul A. Volcker.

The third approach is the view that, subject to a comprehensive and rigorous family of reforms as outlined in Section I, most large integrated financial institutions would be allowed to maintain much of their current configuration while being subject to much more demanding consolidated supervision and clearly falling under the umbrella of “Prompt Corrective Action” and “Enhanced Resolution Authority.”

To many, the frame of reference surrounding the debate on these alternatives seems to be very much a matter of black and white. If we were starting with a clean slate, that might be the case. Unfortunately, we are not starting with a clean slate – far from it. Therefore, allow me to briefly focus on a few observations that – in my judgment – frame the perspective to be considered in shaping the debate on alternative financial structures.

First; in the US and in most other jurisdictions, the public authorities already have broad discretionary authority to remove officers and directors, cut or eliminate dividends, shrink balance sheets and require other steps to strengthen troubled financial institutions. In the US, pending legislation is likely to strengthen this authority and extend it to systemically important financial institutions even if they do not own or control a bank.

Second; given all that we have been through over the past two years, many observers are raising the perfectly natural question of whether society really needs large and complex financial institutions.

I strongly believe that well managed and supervised large integrated financial institutions play a constructive and necessary role in the financial intermediation process which is central to the public policy goals of economic growth, rising standards of living and job creation.

While the business models of the relatively small number of large and complex financial institutions in the US and abroad differ somewhat from one to another, as a broad generalization most are engaged to varying degrees in (1) traditional commercial banking; (2) securities underwriting; (3) a range of trading activities including at least some elements of “proprietary” trading; (4) financial advisory services; (5) asset management services including the management of so-called “alternative” investments; (6) private banking; and (7) elements of principal investing.

While the activities of this small number of international “banks” are broadly similar there is an important structural difference between “European Universal Banks” and “US Bank Holding Companies.” At the risk of considerable oversimplification, the nature of these structural differences relate to (1) strict limitations on transactions between “banks,” and their parents as well as their affiliates; and (2) limitations on the activities of the financial group as a whole.

All of these large integrated financial groups are indeed large with balance sheets ranging from the high hundreds of billions to $2.0 trillion or so. Among other things, it is their size that allows these institutions to meet the financing needs of large corporations - to say nothing of the financing needs of sovereign governments. The fact that so many of these large corporations operate on a global scale is one of the reasons why almost all large financial intermediaries also have a global footprint. As an entirely practical matter, it is very difficult to imagine how the vast financing needs of corporations and governments could be met on anything like today's terms and conditions absent the ability and willingness of these large intermediaries to place at risk very substantial amounts of their own capital in serving these companies and governments. One of the best examples of this phenomenon is the role large intermediaries have played in the recent past in raising badly needed capital for the financial sector itself.

For example, over the past two years banking institutions in the US and abroad have raised more than one-half trillion dollars in fresh private capital and the capital raising meter is still running. While there were some private placements, the overwhelming majority of such capital was raised in the capital markets and the associated underwriting, operational and reputational risks associated with such capital raising, were absorbed by various combinations of the small number of large integrated financial groups. Moreover, many of these transactions took the form of rights offerings which involve extended intervals of time between pricing and final settlement thus elevating underwriting risks. The ability and willingness of these large integrated financial groups to assume these risks depends crucially on large numbers of experienced investment bankers and highly skilled equity market specialists who are able to judge the tone and depth of the markets in helping clients shape the size, structure and pricing for such transactions.

More broadly, to a greater or lesser degree, most of these large integrated financial groups also act as day-to-day market makers across a broad range of financial instruments ranging from Treasury securities to OTC derivatives. The daily volume of such market activities is staggering and can be measured in hundreds of thousands – if not millions – of transactions. As market makers, these institutions stand ready to purchase or sell financial instruments in response to their institutional (and sometimes governmental) clients and counterparties. As such, market-making transactions – by their very nature – entail substantial capital commitments and risktaking by the market maker. However, the capital that is provided in the marketmaking process is the primary source of the liquidity that is essential to the efficiency and price discovery traits of financial markets. Moreover, in today's financial environment, market makers are often approached by clients to enter into transactions that have notional amounts that are measured in hundreds of millions, if not billions, of dollars. Since transactions of these sizes cannot be quickly laid off or hedged, the market makers providing these services to institutional clients must haveworld-class risk management systems and robust amounts of capital and liquidity. Thus, only large and well capitalized institutions have the resources, the expertise and the very expensive technological and operating systems to manage these market-making activities. Having said that, it is also true that some of these activities are, indeed, high risk in nature. Thus, the case for greater managerial focus, heightened supervisory oversight and still larger capital and liquidity cushions for certain activities are all part of the post-crisis reform agenda.

Third; in terms of both competition and regulatory arbitrage there is a critical international component to the outcome of the debate on alternative financial market structures. That is, if, for example, one major country adopted a materially different and more restrictive statutory framework for banking and finance than other countries, the outcome could easily work to the competitive disadvantage of the former country. Moreover, such an outcome would, inevitably, introduce new pressures in the area of financial protectionism which, given the existing threats on the trade protection front, would further increase global economic tensions and risks. It also follows that if there are material international differences in financial structure and the “rules of the road” governing banking and finance, it is inevitable that one way or another, clever people, aided by highly sophisticated technology, will find ways to game the system.

Finally; there are many open questions as to the details associated with the alternative financial structures under consideration not the least of which relate to the extended timeframes that would be needed to implement these changes in a single major country, much less across national boundaries. I, for one, would much rather that the time, energy and public and private resource that would have to be devoted to these restructuring tasks be devoted instead to the timely implementation of the reform agenda discussed in Section I of this Statement.

Section III: The Challenges Associated with Enhanced Resolution Authority

There is widespread agreement in principle that a well-designed and well-executed framework of Enhanced Resolution Authority can address the “Too Big to Fail” and the related “Moral Hazard” problem. Here in the UK, important strides were made in this direction with the enactment of the Banking Act of 2009 which, among other things, provided the authorities with a menu of options for coping with failing financial institutions. In the US and the EU legislative bodies are hard at work in efforts to craft new legislation that would facilitate the orderly and timely merger or wind-down of systemically important failing financial institutions.

While these are encouraging developments, we must keep in mind that a poorly designed and poorly executed approach to Enhanced Resolution Authority could produce renewed uncertainty and instability. Indeed, under the very best of circumstances, the timely and orderly wind-down of any systemically important financial institution – especially one with an international footprint – is an extraordinarily complex task. That is why; at least to the best of my recollection, we have never experienced such an orderly wind-down anywhere in the world. In other words, even if we successfully implement the other reforms outlined in Section I of this Statement, that success by itself, will not ensure that Enhanced Resolution Authority can achieve its desired effects. Thus, great care must be used in the design of and approach to law and regulation for a system of Enhanced Resolution Authority.

I, of course, have no monopoly on thoughts on how to best approach this task. On the other hand, as someone who has devoted much of my career to improving what I like to call the plumbing of the financial system I do have some suggestions as to (1) certain principles that I believe should guide the effort and (2) certain prerequisites that should be in place to guide the execution of a timely and orderly wind-down or merger of a failing systemically important financial institution – especially such an institution having a substantial international presence.

Guiding Principles

First; the authorizing legislation and regulations must not be so rigid as to tie the hands of the government bodies that will administer those laws and regulations because it is literally impossible to anticipate the future circumstances in which the authorities will be required to act.

Second; in my judgment, the authority and responsibility to carry out Enhanced Resolution Authority in a given situation should be vested in governmental bodies that have sufficient experience with the type of institution being resolved.

Third; Enhanced Resolution Authority should provide the flexibility to allow the troubled institution to be placed into temporary conservatorship or a similar vehicle allowing that institution to continue to perform and meet its contractual obligations for a limited period of time.

As a pre-condition for conservatorship, one or more of the Executive Officers and the Board of the institution would be removed. The ongoing approach has many benefits including (1) preserving the value of assets that might be sold at a later date; (2) minimizing the dangerous and panic prone process of simultaneous close out by all counterparties and the need of such counterparties to then replace their side of many of the closed-out positions; and (3) reducing, but by no means eliminating, the very difficult and destabilizing cross-border events that could otherwise occur as witnessed here in London in the Lehman episode. However, the ongoing approach is not without its problems, one of which is the sensitive question of how well an institution in conservatorship for a limited period of time can fund itself.

Fourth; to the maximum extent possible, the rights of creditors and the sanctity of existing contractual rights and obligations need to be respected. Indeed, if the exercise of Enhanced Resolution Authority is seen to arbitrarily violate creditor rights or override existing contractual agreements between the troubled institution and its clients, its creditors, and its counterparties, the goal of orderly wind-down could easily be compromised and the resultant precedent could become a destabilizing source of ongoing uncertainty.

Finally; the orderly wind-down of any large institution – particularly such an institution having a global footprint – is a highly complex endeavor that will take patience, skill and effective communication and collaboration with creditors, counterparties and other interested parties. Shrinking a balance sheet or selling distinct businesses or classes of assets or liabilities may prove relatively simple but the winding down of trading positions, hedges, positions in financial “utilities” such as payments, clearance and settlement systems is quite another matter.

Pre-requisites for Success:

First; as a part of the reform of supervisory policy and practice, supervisory authorities responsible for systemically important institutions must work to insure that “Prompt Corrective Action” becomes a reality and not merely a slogan.

Second; the official community must work with individual systemically important institutions to ensure that all such institutions have – or are developing – the systems and procedures to provide the following information in a timely fashion.

  • Comprehensive data on all exposures to all major counterparties and estimates of all such exposures of counterparties to the failing institution
  • Valuations consistent with prevailing market conditions that are available across a substantially complete range of the firm’s asset classes (including derivative and securities positions)
  • Accurate and comprehensive information on a firm’s liquidity and the profiles of its assets and liabilities
  • Fully integrated, comprehensive risk management frameworks capable of assessing the market, credit and liquidity risks associated with the troubled institution
  • Legal agreements and transaction documents that are available in an organized, accessible form
  • Comprehensive information on the firm’s positions with exchanges, clearing houses, custodians and other institutions that make up the financial system’s infrastructure

I am under no illusion that these guiding principles and pre-requisites are anything close to the last word in seeking assurances that Enhanced Resolution Authority can deliver on the promise of a stability driven solution to the “Too Big to Fail” problem. On the other hand, I very much hope these suggestions will help to stimulate discussion and debate on this critically important subject. I say that in part because I am very concerned that the promise of Enhanced Resolution Authority as the “solution” to the “Too Big to Fail” problem may prove to be far more elusive – especially in cross-border terms – than many politicians and policymakers recognize.


E. Gerald Corrigan
Office of the Chairman